Designing Resilient Monetary Fireworks for the Future

I’ve avoided talking about the Federal Reserve over the past couple of weeks. Considering the number of former bottom-up investors who have converted to Fed experts, who needs one more, right? Plus, I’m biased. Think of me as a factory worker whose job was just replaced by a robot. The robot that eliminated my job artificially inflates asset prices, which reduces the need for fundamental analysis and thoughtful capital allocation. For now anyway. Given the robot operates without rules or constraints, I suspect there will be serious quality control issues down the road. Getting the world’s asset prices just right and keeping them there isn’t as simple as turning a screw!

Bill Gross was out again last week making sense. He said the economy “may never walk normal again.” I agree, but I’d also add the financial markets may never walk normal again. And that’s what really concerns me as an absolute return investor who thrives in free markets. I continue to be surprised there aren’t more professional investors like Bill Gross expressing their concern and displeasure with monetary policy overreach. Whether the asset management industry is willing to acknowledge it or not, asset price fixing or support is very bad for business. Although asset inflation can cover a lot of mistakes in the near-term, assuming volatility remains suppressed and fundamentals continue to lose relevancy, passive investing will take market share. Why hire an active manager if asset prices are fixed and markets are controlled?

Instead of taking a stand against monetary policy, some professional investors seem to be spending more time and attention trying to become policy experts. I watched a small amount of financial television last week and couldn’t believe the amount of coverage committed to monetary policy. Leading up to Yellen’s speech, there was a parade of “experts” giving their opinions. It was amazing. I even think there was a countdown clock to the speech on one network. Good grief!

Most of the experts and commentators were focusing on whether or not the Fed will raise rates in the coming months. Although I’m not a Fed expert, this wasn’t what I was focused on last week. Instead, as a proponent of free markets, the news that caught my attention was Yellen’s comments regarding future QE. Specifically, near the end of her speech, Yellen said, “…I expect that forward guidance and asset purchases will remain important components of the Fed’s policy toolkit.” Considering how inaccurate they’ve been, I’m not sure many people care about their forward guidance. However, the statement regarding future asset purchases should have grabbed investors’ attention. And if that didn’t, the following comments she made certainly did. “On the monetary policy side, future policymakers might choose to consider some additional tools that have been employed by other central banks…”

Some of the additional tools Yellen is most likely referring to is the purchase of corporate stocks and bonds (following the lead of the ECB and BOJ). The thought of our government buying private assets of corporations literally upsets my stomach. First the Federal Reserve monetizes trillions of dollars of U.S. Treasuries and mortgages, and now they’re openly considering nationalizing private corporations (at least partially). Wow.

The other theme that came out of Jackson Hole is that the economy is improving and is better able to withstand a rate hike in September or December. While company news flow has been slow over the past few weeks, on average, the companies that are reporting results are not indicating a change in trend. Based on the fundamentals of the companies I follow, I continue to believe Q3 2016 will not differ meaningfully relative to Q2 2016. Two examples on my possible buy list, Tech Data (TECD) and Big Lots (BIG), reported results last week. Both companies reported stagnant sales with little change in business trends or outlooks.

Tech Data is one of the world’s largest distributors of technology products. Tech Data reported sales declined -3%. Management was disappointed with their results. On their conference call management stated IT spending was weaker than expected. Management noted that as they progressed through the quarter their market slowed more than anticipated with mobility being particularly weak. With $26 billion in sales in 2016, Tech Data sells a lot of product and is a good barometer of technology spending. Big Lots was the other company on my buy list that reported results. Big Lots is a discount retailer with 1,445 stores in 47 states. Sales for the quarter were practically flat with same store sales up 0.3%. During their conference call, management called the retail environment choppy. While Tech Data and Big Lots are only two data points, their results aren’t too dissimilar from those of other companies recently reporting. Organic growth, on average, remains slow.

As I discussed in my July 22 post “Examples Please”, a good defense against financial spin is asking for specific examples. My question for the Federal Reserve is, “If you are data dependent, point to specific examples where you see a meaningful change in operating results? What part of the economy, specifically, is performing noticeably better since your last policy meeting?” In my opinion, operating results of businesses have changed little over the past several quarters. It’s been consistently stagnant. What does the Fed see that businesses don’t?

In conclusion, it appears like more of the same from companies in Q3 and the Federal Reserve post QE3. I continue to wait for The Great Normalization, with its arrival time unknowable. After reviewing Yellen’s comments on Friday, it appears central banks plan to remain very involved in the financial markets and they are open to becoming even more involved. Bill Gross is concerned. I’m concerned. So there’s two of us (yes, I’m very aware I’m not Bill Gross). It’s not much, but it’s a start!

I remain optimistic other investors will gradually come to their senses and say enough is enough as it relates to inflated asset prices and playing a role in the central banks’ script. From the book Extraordinary Popular Delusions and the Madness of Crowds, “Men, it has been well said, think in herds; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one.”

What a wonderful quote and how relevant today.

Closely Held Premium

National Beverage Corp. (FIZZ) is an interesting small cap company. FIZZ produces sodas, sparkling waters, juices, and energy drinks. Brands include LaCroix, Shasta, Faygo, and Rip It. With a $2.3 billion market cap, they’re not as small as they used to be. The business has done very well recently and so has their stock. Similar to most high quality small cap stocks these days, FIZZ is too expensive for me. With a P/E of 38x and P/S of 3.3x, I’ll be looking elsewhere to quench my thirst for value. Nonetheless, I wanted to use FIZZ to make a couple of interesting observations.

First, FIZZ has no analyst coverage. How does a $2.3 billion market cap company not have analyst coverage? I follow $100 million market cap companies that have several analysts covering their stocks. The answer can be found on FIZZ’s balance sheet and in its proxy statement (top holders). FIZZ has an excellent balance sheet with $100 million in cash and no debt. In effect, it’s overcapitalized and does not need Wall Street funding. Furthermore, management hasn’t caved into the pressure of the Wall Street Locusts (see past post on this subject) and has not leveraged up its balance sheet to aggressively acquire.

The reason FIZZ has been able to protect its balance sheet from Wall Street Locusts is the company is closely held.  The Chairman and CEO, Nick Caporella, owns 73.8% of the company. In effect, he can run the business however he wishes and doesn’t need Wall Street’s help. Running the business independently seems to be working just fine. Instead of growing through acquisitions, FIZZ has used internal capital to grow organically. Recent results suggest this was the right strategy (sales up 17% last quarter).

Many analysts and investors put a discount on closely held businesses. They don’t like the fact that an individual or a family has the major say in running the business. I view closely held businesses differently. What if the majority holder has a long history of being a good allocator of capital? What if the majority holder has been shareholder friendly and grown the business prudently? What if the majority holder actually is a good business person? Why should I apply a discount to this? In fact, I believe closely held businesses are often in a better position to manage the organization for the long-term. For example, they don’t have the same near-term pressures as most companies, such as winning the quarterly estimate game. It’s also easier for closely held businesses to grow organically versus growing through acquisitions and financial engineering (as majority owner there’s no need to fool yourself).

In FIZZ’s case, being a closely held business hasn’t been such a bad thing. They have a great balance sheet and a business that is performing very well. The investment they made in their brands is paying off. If they were managed under the influence of Wall Street, it’s possible their investment in brands would have been curtailed to meet near-term quarterly earnings guidance. It’s also possible they would have acquired and would be more focused on reducing debt than growing the business. These are all just possibilities, but one thing is certain, its stock is up 500% over the past 10 years. So much for the closely held discount. FIZZ is now trading at a meaningful premium to the market and its peers.

I like FIZZ, but again, the stock is too expensive for me at this time. I will continue to follow their business and hopefully one day I’ll get a chance to buy them at a discount. That said, I won’t be applying a closely held discount to my valuation.

On an entertaining note, if you’ve never read a FIZZ press release, I suggest you pull a few up. The CEO has a lot to say and he says it very enthusiastically! If there was a CEO touchdown dance competition he wins – hands down. I listed some samples below. Enjoy and have a great weekend!

“When does authenticity stop being a trait and become a stalwart description?” was the question posed to Nick A. Caporella, Chairman and Chief Executive Officer. “When absolute performance demands it,” was his answer!

“When one looks at growth potential combined with quality of earnings and unprecedented consumer demand, the question is not one of value . . . but one of indeterminable potential!!”

“Indeterminable potential is not only the result of excellent fundamentals . . . but, more profoundly – Genius Innovation! We are on the right side of novel . . . where dynamics such as product development, packaging, Innocent ingredients, millennial optics and shelf marketing are uniquely synthesized. The Result = Indeterminable Potential!” smiled Caporella.

“Our normally strong first quarter of a new year usually predicts a good year-over-year growth probability. This first quarter will see revenues exceed $200 million for the very first time – another respectable milestone . . . Yes!”

“We will have a great FY2016 – and beyond! Never quite like this present time, has the promise belonging to National Beverage been this exciting. The goals for our brands, shareholder value, balance sheet, revenues, earnings and cash buildup are all aglow like that orange ball rising; Shouting Loudly – yes . . . it’s all happening right now!”

Dummies is no Dummy

A friend of mine wanted to learn about bonds so he picked up the book, Bond Investing For Dummies, 2nd Edition. As a reader of this blog, he thought I’d like the book’s introduction. He was right! I couldn’t have said it better myself.

“Those who make the most money in the world of investing possess an extremely rare commodity in today’s world – something called patience. At the same time that they’re looking for handsome returns, they are also looking to protect what they have. Why? Because a loss of 75 percent in an investment (think tech stocks 2000-2002) requires you to earn 400 percent to get where you started. Good luck getting there!”

“In fact, garnering handsome returns and protecting against loss go hand in hand, as any financial professional should tell you. But only the first half of the equation – the handsome returns part – gets the lion’s share of the ink.”

After reading the introduction, I readjusted my perception of the “Dummies” books. The book’s title also caused me to think about another misperception — that all successful investors are extremely smart. There is no doubt Wall Street is filled with very smart people. In fact, there’s probably an excess supply of smart people in the asset management industry. Imagine the progress we could have made as a society if only a fraction of the investment world’s brain power was unleashed on other important endeavors and challenges. Here we are in the third asset bubble in 20 years and we have some of the best and brightest people in our country spending their entire day deciding whether or not to buy a bond yielding practically nothing or a stock trading at twice its justifiable valuation. In my opinion, it’s a significant misallocation of human capital.

The efficient allocation of human capital is an interesting topic, but it’s one for another day. The point I’d like to make is you don’t have to be the valedictorian of your class or graduate from a top business school to be a good investor. I have nothing against brainiacs. In fact, I’ve had the privilege and pleasure of working with some very smart people who were also very good investors. They had multiple degrees from incredible institutions. I remember when I worked in New York I was one of the few analysts who didn’t graduate from a top business school. I tried to convince them Stetson University was the Harvard of the south, but no one bit on that one. They were too smart!

While I didn’t graduate from Harvard, I did study and I did make good grades. I also had a few other things going for me. First, I loved investing. Loved it. And I still do. You can’t teach how to be passionate about a subject or occupation. Either you love doing your job or it’s just a job. Investing has never been just a job for me. It’s something that follows me throughout the day, every day. I find it so fascinating. My mind never tires of attempting to figure out the incredibly complex jigsaw puzzle of financial markets, economies, and the hundreds of companies I follow. If you are passionate about investing, I believe you have a big advantage over investors who are simply in it for the money and spend their free time planning their next trip to the Hamptons.

Another underappreciated characteristic of successful investing is common sense. I believe common sense is essential for contrarians and absolute return investors. Some of my favorite investors use a healthy dose of common sense in their decision making. They have a tendency to invest differently near peaks and troughs of the market cycle. They invest differently not out of defiance, but because it’s rational and it makes sense to them. By using basic reasoning and common sense, they’re able to debunk end of the cycle “this time is different” theories, such as T.I.N.A. and perpetual central bank backstops.

I also like to use common sense in my business valuations. For example, I use a required rate of return that makes sense to me – a hurdle rate that properly reflects my interpretation of the quality and risks of the business, not one driven by a rigid academic model or risk-free rates. I also use normalized cash flows in my valuations, not peak or trough cash flows. This isn’t something I learned from a book or a professor, it’s simply a common sense driven approach that I developed over time.

Similar to common sense, is business sense. Some people are just blessed with the mindset of a business owner. They don’t need spreadsheets, regression analysis, or detailed valuation models. They just get it and understand the business and its worth. I’m always impressed with investors who can quickly discover the most important variables influencing a particular business. An investor with good business sense can cut through volumes of data and noise and pull out the three to five most important things about the business. This enables the investor to quickly understand what drives a business’s current and future cash flows. In my opinion, this is essential for an accurate assessment of the business and for creating realistic valuation variables.

Lastly, there is a tremendous amount of intangibles and subjectivity involved in investing. Being book-smart can only get you so far. How do you control your emotions at market extremes and when dealing with individual investments that are not going your way or are screaming over fair value? Successful investors have a certain temperament that is conducive to clear thinking and rational decision making throughout the market cycle. This trait can’t be measured by grades and diplomas and usually can only be determined on the field of battle.

In conclusion, don’t be a dummy and assume having the biggest brain and the fanciest diploma will guarantee investment success. Other qualities such as passion, common sense, business sense, and temperament can go a long way in helping investors generate attractive absolute returns.


Bubble Management

The last cycle, or asset bubble, worked out well for me. We sold our house in Florida near the peak and rented for two years. It was equivalent to what I’m doing now by selling stocks and going 100% cash – I wanted out of the market completely. I remember people thought I was crazy, just as I’m sure many do today. However, making the switch from owner to renter was a good move and allowed us to buy at a much more attractive price after the housing market slowed.

The absolute return strategy I manage also performed well during 2008-2009, as I was able to avoid most of the carnage in 2008 by being patient (sound familiar?) and then found considerable value in small cap stocks in late 2008 and early 2009. Getting aggressive when getting paid to take risk paved the way for attractive gains in 2009. Although the cycle was a success in relative and absolute terms, in hindsight, given my views on the real estate bubble, I could have done even better.

In 2006, I felt strongly about what was coming. Signs of the bubble were all around us. In an effort to document the mania, I drove to the beach and took pictures of all of the condos being built. It was stunning – they were going up everywhere. The joke was the new Florida bird was the crane, the construction crane. My neighbor told me he just paid off his car. I said, “Congratulations!” He said, “Yeah, I did it by taking out a home equity loan.” It was a crazy period and I was confident it was a bubble. I tried to convince anyone who would listen. At the peak of the cycle, it seem liked only Jimmy and Pete were listening and even they were tired of hearing the same story walk after walk (they’re my dogs). I had friends laugh at me. They called me names I’d prefer not repeating because they were actually funny and I’m concerned they’d stick! Similar to this cycle, my positioning was unique and unpopular.

Although it often felt like I was alone, there were others who also saw the housing bubble. In fact, a friend, who is a mortgage broker, and I discussed the bubble frequently. He was one of the few people I knew who understood the plumbing of the housing and mortgage markets. One day we both gave each other convincing arguments of why we were near the peak. He gave me examples of how insane things were getting in the mortgage business. I provided broader data such as mortgage debt growth and home prices versus incomes. Together we were very confident the cycle was about to end. While I felt I had already prepared for what was to come, I questioned myself on whether I should have leveraged my beliefs more aggressively. Had I done enough?

I have similar feelings today about stocks and bonds and I’m also asking similar questions as it relates to my positioning. While I feel I’m properly prepared for what’s to come, should I leverage my beliefs further? In addition to going 100% cash, should I short or buy put options on individual stocks or the market? While I’ve bought a small amount of put options and shorted stocks in the past, they’ve been small weights that better resemble a vote against irrational markets than a meaningful short position. I’ve never been aggressively short the market.

While shorting overvalued assets makes sense to me, I think it’s important to acknowledge we’re all investment specialists to some degree and we all have our limits. Knowing exactly when overvalued markets revert is one of my limits. As I’ve acknowledged on several occasions, I’m not a market timer. Although I have a good track record of spotting overvaluation and asset bubbles (this is my third bubble), my observations have come months if not years before the cycle ends. In other words, I have a history of being right, but early.

Being early can work very well with a high quality stock, but it can be disastrous when shorting or buying put options. Nevertheless, when I feel strongly an asset class is overvalued, it’s difficult to refrain from attempting to make a profit from its eventual decline. I believe investors attempting to profit from an asset bubble’s demise have two options. Investors can simply sell and stay liquid (essentially my strategy last cycle and this cycle) or sell short and buy put options. By moving to all cash and remaining patient, the biggest risk is opportunity cost, or missing out on future gains. By shorting and buying put options, an investor assumes timing risk and considerable risk to capital. Deciding which option to take depends on each individual’s investment objectives, risk tolerance, and core competencies. With a good understanding of myself as an investor, my plan remains to be patient, liquid, and ultimately buy small cap stocks at lower prices.

As an absolute return investor, I believe my strategy of patience makes sense. Getting aggressively short and timing the end of a bubble’s life requires speculation – that’s something I’ve always attempted to avoid. Nevertheless, I can’t help but remember the last time I had this feeling and missed “The Big Short”. Even if things worked out very well last cycle, I admit it would have been more fun to make billions off derivatives and then be depicted in a movie! I guess patience isn’t exciting enough for a book and movie deal. But it would be a good bedtime story. There once was an investor named Eric. He sold all of his stocks and waited….zzzzz.

What’s Important to You?

As absolute return investors, we often need to look different, sometimes a lot different, than the benchmarks and our peers. To generate attractive absolute returns over a market cycle, it’s important to be able to pull back when others are pushing forward and push forward when others are pulling back. Fighting the seductiveness and comfort of being included in the crowd is very difficult – a tremendous amount of discipline is required.

Discipline is a trait every investor claims to possess. What professional investor starts a presentation with, “Hello, my name is Bob. I’m an undisciplined portfolio manager. Will you hire me?” While everyone claims to be disciplined, it’s extremely difficult to maintain discipline throughout an entire market cycle, especially the type of cycles (asset bubbles) we’ve had over the past 20 years.

This is my third market cycle. Each cycle my investment discipline has been put to the test. Given today’s markets are extraordinarily expensive and the overvaluation is so broad, the current cycle has been particularly challenging. Despite these challenges, I believe I’ve remained disciplined as I have in past cycles. In fact, the commitment I have toward my investment discipline is one of the reasons I recommended returning capital to clients and moved to 100% cash. Considering valuations within my opportunity set, investing in small cap stocks today would most likely cause me to violate my discipline. I don’t want to be like the portfolio manager “Bob” mentioned above, so here I am. [If your name is Bob, please forgive me!]

The discipline of professional investors is often communicated as a set of rules and guidelines. Investment guidelines are typically listed front and center in presentation booklets. Guidelines are used by asset managers to communicate how a strategy will be managed. Guidelines are also used to reassure clients or potential clients that the manager will stay in their appropriate style box. For relative return investors, remaining in a style box is important, as many are hired with the assumption that they will act a certain way relative to a benchmark and peers. For example, if you’re a mid-cap growth manager, rules and guidelines will be set to make sure you invest like a mid-cap growth manager.

In my opinion, an investment discipline founded on how a manager is labeled is often too restrictive and encourages conformity. By following label-driven guidelines, a manager who follows their discipline is – by definition – following the crowd. A manager’s investment beliefs and opinions can be overridden by rules and mandates. In other words, how the manager wants to invest and how he or she is allowed to invest, may be two entirely different things. In my opinion, this isn’t investment discipline, it’s compliance – there’s a big difference.

I view discipline differently than a set of rules that keep a manager from stepping outside of a particular style box. I view discipline as a set of core investment beliefs and principles. While I have rules and guidelines, most are meant to increase flexibility, not decrease it. If I believe something to be true or have a strong opinion, I can act on it. My discipline is not restrictive and does not commit me to a particular style or label. Furthermore, most of my guidelines are qualitative in nature and do not impose strict quantitative limits. Instead of a rigid set of rules and guidelines, my discipline revolves around defining what I believe is most important to me as an investor and a person.

In previous posts, I’ve referred to a couple of guidelines as part of my Ten Investment Commandments. I’ve listed all of them below.

Eric Cinnamond’s Ten Investment Commandments

  1. Do not overpay (be willing to be patient).
  2. Take risk when getting paid (be willing to be aggressive).
  3. Think independently (be willing to invest differently and uncomfortably).
  4. Do not value what can’t be valued (avoid speculating).
  5. Do not extrapolate (normalize).
  6. Do not combine operating and balance sheet risk (avoid major losses).
  7. Do not manufacture opportunity (use realistic valuation variables).
  8. Do not manage money to get hired (don’t play the AUM game).
  9. Know your names; be dedicated to your opportunity set (300 name possible buy list).
  10. Obtain fundamentals from companies, not the government, media, or sell-side research.

What’s important to you as an investor? Throw away the generic rules and policies. Also toss out all of the best-selling investment books and your favorite Warren Buffett quotes. Make a list of the things that YOU believe are important, not others. The list should be based on individual beliefs and not driven by a style box or how you believe others want you to invest. What defines you as an investor?

The next time you question an investment or your discipline, go to your list and you’ll often find the answer. Furthermore, I believe you’ll find a personalized list will help define and differentiate yourself. In an investment world that is moving more and more to passive investing and conformity, I believe different will be a precious investment resource when the current cycle ends. Without a unique discipline, few will be able to offer it.



Investment Closers

Considering I grew up outside of Louisville Kentucky, I know a little bit about horse racing. There are a lot of similarities between horse racing and investing. Horses have track records and statistics you can analyze. Betting odds are good measures of risk and reward, with handicappers attempting to discover market inefficiencies. Think of the trainer as the board of directors and the jockey as management. The distance of a horse race is measured in furlongs. Races usually range from five to slightly over eight furlongs – not too dissimilar from markets cycles when measured in years. As in investing, there are different strategies. Three of the most popular strategies are front-running, stalking, and closing.

Front-runners attempt to steal the race by breaking out early and separating from the pack. When you hear a horse went wire to wire, that’s usually a front-runner winning. A stalker hangs just a few lengths back and makes its move near the end of the race. The stalker does well if there are several front-runners that wear themselves out fighting for the early lead. The closer stays even further back from the front-runner and may look like a complete loser for most of the race. But don’t throw away your ticket just yet! The closer often shines at the end of the race, when the front-runner and stalkers have made their moves and are suffering from exhaustion.

Similar to horse racing, in investing it’s important to know what type of race you’re in and what type of race you should run. This is a long cycle. Being an investment closer makes sense to me, especially at this stage of the cycle. Chasing returns and other investors can wear you out. Save energy and capital for the stretch – you’ll need it! No one likes to be in last place, but there are times when it’s a good strategy.

Closers can often look like they don’t even belong in the race. They’re boring and steady. But then it happens. As the race (or cycle) nears its end, everything changes. The jockey and the horse knew they weren’t out of the race. It was their plan all along. There’s nothing quite like watching a closer come down the stretch after being 10-15 lengths back and blowing past the leaders.

Zenyatta was one of the best closers of all time. Even today, watching her race gives me goose bumps. If you’re struggling at this stage of the market cycle and feel like you’ve been left in the dust by all of the front-runners, I encourage you to watch this two minute race posted by Betfair Hollywood Park. Put yourself in the saddle of the 5 horse (Zenyatta). Enjoy!





1% of 1% of the 1%’ers Cut Their Own Lawn

I like cutting the lawn. Maybe this is because I grew up in The Bluegrass State where grass grows thick and quick. Or maybe it’s because I like the sense of accomplishment I receive immediately after I mow the lawn. This is very different than absolute return investing, when some of the best investment ideas can take years to play out.

Since I was old enough to push a mower, I’ve done most of my grass cutting with a Brigg’s and Stratton (BGG) engine. I’d put my grass cutting track record up there with any portfolio manager (I grew up on 10 acres!). I’m certain I’m at least top quartile, especially on a push mower-adjusted basis.

While I’ve always mowed with a Briggs & Stratton in the past, I recently swapped to a Honda mower as my Brigg’s engine was sputtering (possibly choking on ethanol). In any event, it was a tough decision, but so far so good with the Honda.

I hope my switch to Honda didn’t hurt Briggs & Stratton’s earnings last quarter. It was a weak quarter as the company reported a -6% decline in sales and a -3.4% decline for the year. Management blamed cooler than normal spring weather and global economic uncertainty. Despite the tough quarter, I thought management did a great job explaining the current trends in sales, especially the divergence between the “haves” and the “haves not as much”.

As in other parts of the economy, on average, higher-end consumer businesses are performing better than middle to lower-end. I’ve touched on this in previous posts, providing specific examples of consumer companies reporting sales increases and sales declines. In general, businesses with customers exposed to asset inflation are performing better than those with customers that rely solely on wages. Briggs & Stratton is seeing a similar divergence within its business segments.

Specifically, despite negative sales growth for the company overall, its commercial turf business generated a record year. Management credited innovation and an “improved housing market for high-end and multifamily homes”. In other words, the segment of the real estate market that is more likely to use professional lawn services.

Management believes the housing market is “choppy” with the high-end and multifamily segments performing well while other segments struggle. Management provided interesting commentary stating, “…starter and step homes have continued to be weak. Surveys have shown household formation is occurring later in life for millennials. And when they form a household they’re more likely to rent than own.”  While management believes millennials want to become homeowners, they also acknowledged there may be a delay. “We believe that delayed life milestones combined with an increase in student loans and more stringent lending practices have delayed first time homebuyers entering the market. Plus there appears to be a shortage of starter homes as builders focus more on higher-end houses.”

“This notion of a choppy housing market is reflected in our business. Industry shipments of walk behind mowers, the type purchased by new homeowners, declined this year while industry shipments of higher-end ride-on and commercial equipment, the type purchased by high-end homeowners and commercial cutters increased. We have maintained for some time that the U.S. mower market is highly correlated with new and existing home sales and what we have observed over the last year reaffirms this.”

I think Briggs & Stratton just summed up the economy. If you’ve benefited from asset inflation you have a nice ride-on mower (or your professional does). If you haven’t benefited and rely on stagnant wages, you’re struggling to afford a push mower. There are many reasons why I dislike this cycle and why I believe it’s unsustainable. This is one of them.


Money For the People

While watching Bloomberg TV tonight I noticed the following headline, “Protesters Tell Bank of England Bond-Buying Plan Isn’t Working”. The article says 40 protesters chanted, “Create money for people, not financial markets.” It was only a matter of time before the general population figured out it’s better if the money printing was distributed directly to them instead of benefiting only those with exposure to financial assets.

I suspect the protests and pressure will grow until politicians eventually agree. QE for the people will most likely be launched during the next recession. An easy political test-run in the U.S. would be a stimulus package that forgives student debt ($1.3 trillion or so) and pays for it with QE or helicopter drops (essentially the same thing as QE but without the middleman). It would be a popular program and tough to argue against politically, but easy to argue against with any knowledge of monetary history. Infrastructure spending would also be a front-runner. Whatever the QE cannon is focused on, I’m not sure I’d want to own no to low yielding bonds once QE for the people is implemented, or even discussed.

Penalties Offset – Replay Third Down

Several consumer companies reported results over the past two weeks. After reviewing Q2 earnings reports and conference calls, I concluded consumer businesses were experiencing a slight slowdown. Since then, I’ve been paying close attention to consumer businesses and remain on the lookout for changing trends. Over the past few days, I’ve reviewed several consumer companies’ quarterly reports and conference calls and provided brief summaries below.

Ralph Lauren (RL) reported weak results, but its stock moved higher as it won the earnings estimate game (weak results were expected/restructuring). Total sales declined -4%. Wholesale segment revenues declined -5% mainly due to challenging traffic trends at U.S. department stores. Retail segment sales declined -3% and same store comps declined -7%. Management blamed lower traffic and a challenging economic environment. Interestingly, online sales declined -6%. Management noted it is “harmonizing” its pricing. The company is expecting revenue to decline low double digits in fiscal 2017 due to “a proactive pullback in inventory receipts, store closures, pricing harmonization and other quality of sales initiatives combined with the weak retail traffic and a highly promotional environment in the US.”

TJX Companies (TJX) reported solid results, but apparently lost at the future earnings estimate game, as its third quarter outlook was disappointing. Same-store sales were relatively strong in my opinion, up 4%. Management noted most of the comp increase was due to traffic, which is different than most consumer companies I’ve reviewed (traffic and transaction growth was weak last quarter, even for companies reporting positive comps). As operating results suggest, management believes they are gaining significant market share. All things considered, it looked like a good quarter to me. But what do I know — its stock actually declined on one of the better retail reports I’ve seen recently. At 22x 2017E earnings, I’m assuming part of the negative response may have been valuation based. Also while 4% comps are well above average for retailers, comps are slightly below last year’s average of 5%.

Dicks Sporting Goods (DKS) reported satisfactory results that the market seemed to like. While same store comps were up a moderate 2.8%, investors were relieved The Sports Authority liquidation appeared to have little impact. The exact impact is unknowable and we’ll have a much cleaner comp next quarter. On the conference call management noted sales actually benefited from the liquidations at the end of the quarter. Finally, on traffic, management said, “DICK’S Sporting Goods omnichannel same-store sales increased 3%, driven by a 1.3% increase in ticket and a 1.7% increase in traffic.“ Given the uncertainty regarding how competitor inventory liquidations impacted results, I don’t believe it’s a good idea to use Dicks’ operating results as a broader macroeconomic data point at this time.

Target Corp. (TGT) reported poor results and lost at the earnings game. I have not reviewed their conference call yet, but same store comps declined -1.1%. Same store comp expectations for the second half (where’s the second half recovery?) are 0% to down -2%. Once I read their conference call I’ll know more, but it appears to be simply general weakness.

The Home Depot (HD) reported solid results with 4.7% growth in same-store sales. Interestingly, a large portion of this increase was due to the average ticket growing 2.5% while transactions were up 2.2%. This is similar to what I’m seeing with most consumer companies reporting positive comps – a meaningful portion is coming from mix and price. According to management, “…big-ticket sales in the second quarter, transactions for tickets over $900, representing approximately 20% of our US sales, were up 8.1%. The drivers behind the increase in big-ticket purchases were HVAC, appliances and roofing.” In my opinion, relative to other retailers, Home Depot is benefiting more from asset inflation. Considering I believe asset inflation is unsustainable, I would argue Home Depot’s sales trends are at greater risk to The Great Normalization (when asset prices revert to fair value). Nonetheless, its current business is performing well and it was a solid quarter.

Lowe’s Cos. (LOW) results were slower than expected and it also lost at the earnings estimate game. Comparable sales were up 2% while U.S. based stores were up 1.9%. Average ticket was up 1.7% and transactions were only up 0.3%. Ticket size over $500 was up 2.9%, which is well below Home Depot’s high ticket size transaction growth. I would have expected Lowe’s to benefit more from asset inflation. Interestingly, in their quarterly slide presentation they note appliances performed only “average”. I haven’t read their conference call yet, but based on the press release and slides, it looks like a sluggish quarter given the macro benefits they should be experiencing.

In conclusion, after reviewing these quarterly reports and conference calls, I believe it’s difficult to draw a conclusion as it relates to changing consumer spending trends. Overall general merchandise appears weak, while consumer companies positioned closer to asset inflation, such as Home Depot, continue to perform better. However, when viewing business trends based on transaction growth, even the companies performing better are not reporting particularly strong results. Gains based on price and mix are beneficial, but I’d argue are more dependent on the sustainability of asset inflation and the consumer’s willingness and ability to pay more. Overall, I’d call these reports mixed and inconclusive – penalties offset, replay third down! As we get more data I’ll put it all together and try to determine if Q2 was a blip or something we should be more concerned about. Or more accurately, what investors in stocks should be concerned about. I remain out of equities entirely.

Is This Investing?

I had a very interesting conversation with an experienced value investor last week. We talked about a variety of topics, but one question he asked me really stood out and I continue to think about today. Has the investment landscape changed permanently? It certainly feels that way. However, we need to be careful in declaring so, as the history of financial markets is littered with “this time is different” corpses.

This is an important topic for me and for thousands in the investment management industry. If things have permanently changed, there is little need for fundamental research and experienced investment judgement. Instead of continuing to follow my 300-name possible buy list and organizing my thoughts on this blog, maybe I should be in trade school learning how to wire a house, or even better, make an irresistible pizza!

I touched on this subject in an earlier post, “If You Think Nobody Cares About You, Try Missing a Couple Payments.”  In the post I wrote, “I don’t know what to call allocating capital in these markets, but I’m reluctant to call it investing. That’s a shame given the extraordinary amount of human capital being consumed by the investment management industry. If central banks fix asset prices how is this investing? If this isn’t investing, what is it? And if we all know prices are fixed and artificial, why are so many playing along?”

Is this investing? It’s a very relevant question in today’s financial world. Is buying a bond with a negative yield investing? By definition it is not. Investing is defined as committing capital with the expectation of receiving an income or gain. Assuming a negative yielding bond is held to maturity there is no expectation of receiving income, only losses. It is not investing (I’m sure you didn’t need me to tell you that!).

I have a different definition of investing. To me investing is much broader than simply committing capital to make a profit. It’s a process. A lot goes on from the time I discover an investment idea, perform due diligence, and make the purchase and eventual sale. For me, and for thousands of fundamental-based investors, it’s a long and thorough bottom-up process with a healthy mixture of critical thinking and subjectivity. Over this long process, I build an understanding of a business and develop an opinion of its intrinsic value. I then compare my opinion of the business’s worth to its market price. Seems simple enough, right?

I suppose it is. And I suppose the investment process as it relates to determining an asset’s intrinsic value hasn’t changed, but what about the purchase and sale portion of the process? The purchase and sale portion of my investment process often relies on changing fundamentals to create opportunity (purchase) and drive the investment’s price to my calculated valuation (sale).

Let’s assume market prices are not allowed to fluctuate based on fundamentals. Instead, policy makers interfere and asset prices are set to levels they deem appropriate, not by market participants. In such an environment, market participants are price takers, not price makers, and fundamentals become less relevant. Is this still investing? Not as I define it.

In my opinion, the prices investors are now taking do not accurately reflect the true risks underlying a variety of investments, ranging from “risk-free” government bonds to small cap stocks. Risks, along with other fundamental variables, are becoming less of a factor in determining asset prices.

As fundamentals decline in importance, the value investors place on the perceived safety of central bank price fixing, along with their reassurances that financial instability will not be tolerated, is growing. This new and intrusive investment variable, the central bank backstop, is difficult to value as the exact premium for its perceived “safety” is unknowable. Nonetheless, I believe it’s having a significant impact on how investors view and justify inflated asset prices.

This time is not different, but the cycle is…

I believe the pricing mechanism in financial markets is broken and asset prices are currently artificially inflated. Simply put, the prices of stocks and bonds would not be where they are today without central bank intervention. I don’t see how this is debatable. Whether asset prices are directly or indirectly set by central banks could be up for debate, but in my opinion, financial markets are not functioning properly and are not moving freely.

As I’ve attempted to illustrate in previous posts, asset prices are not properly responding to fundamentals, which is further evidence markets are malfunctioning. Despite this, I’m optimistic free markets will return with fundamentals and valuations eventually retaking the throne of what’s most important.

When free markets return and valuations normalize, I believe asset prices and opportunities will improve considerably. It is why I continue to follow the companies on my possible buy list and remain engaged with the financial markets – I’m waiting for what I call “The Great Normalization”. Although I believe free markets will return, I do not know when the normalization process begins, or how long this period of artificial asset prices lasts.

It’s understandable why so many believe the investment environment has changed permanently. Central banks appear to be in complete control as every little hiccup in the market is met with decisive verbal or real countermeasures. It really does feel different this time. But don’t all asset bubbles feel different? The often cited Irving Fisher quote from 1929, “Stock prices have reached what looks like a permanently high plateau” is often ridiculed, but how different is this quote from the actions most investors are taking today?

Since investors are willing to pay current prices for stocks and bonds, they must believe something has permanently changed. Investors can’t believe stocks and bonds are good investments while also believing interest rates, profits, and valuations are going to normalize. When normalization occurs, investors will most likely incur significant losses. Therefore, buying assets at current prices implies investors believe rates will not normalize and valuations will remain well above historical norms. In other words, today’s investors are making the same assumption as Irving Fisher in 1929, that this time is different (ironically in 1929 the cycle was eight years old – sounds familiar!).

While I don’t believe things have permanently changed, I am aware that this cycle is different than past cycles – there has never been this type of coordinated monetary policy response. The last cycle (2003-2008) was just a good old-fashioned credit bubble. There was a limit to how far it could grow before it burst. For example, a bank’s balance sheet can go from 10x leverage to 20x leverage and maybe even 30x leverage, but its leverage can’t expand indefinitely. A central bank’s balance sheet is entirely different. In theory, a central bank’s balance sheet can expand indefinitely as there is no limit to the amount of money it can create to purchase assets.

Central banks’ unlimited purchasing power is reassuring to many, but for others (like myself) it’s extremely unsettling. Instead of raising taxes or cutting spending, why not print money to pay for the next need of the moment? It starts slowly and picks up speed as politicians and policy makers figure out an endless supply of “money” and crowd appeasement is literally a keystroke away. How will this power not be abused? And how has it not already been abused? How much debt has already been monetized globally to fund government deficits and spending? I believe it’s around $12 trillion and growing considering the ECB and BOJ continue to monetize stocks and bonds.

Monetary policy uncertainty and risk premiums

While the consequences of eight years of emergency monetary policies as it relates to asset inflation is clear, there are other consequences that are less obvious. One is the large number of investors that were once obsessed with bottom-up fundamental analysis, are now experts in central bank policy (this was another interesting topic of conversation I had with the experienced value investor). How can we all be experts on something that has never happened before? While we should acknowledge the influence central banks are having on financial markets, how can any of us know exactly how things unfold and what the ultimate consequences of these extreme monetary policies will be?

I argue we don’t know and we can’t know. And this includes the central bankers themselves! As such, shouldn’t the biggest uncertainty facing investors today (global monetary policy) be a reason to require a higher return on assets, not less. Considering we have never experienced these sort of monetary experiments before, along with the fact that whenever it has been tried by an individual country it’s ended badly, why are investors paying record prices for stocks and accepting record low yields on bonds? In effect, the investment environment is more uncertain today (risk higher) due to global monetary policies, not less. Can anyone name one instance when monetizing debt was successfully implemented and exited from? As a newly unemployed person, I’m open-minded to the wonders of money printing. If monetizing debt and helicopter drops work, let’s get on with it so we can all retire!

The last credit and economic cycle was very different than today’s central bank driven cycle. An investor could locate the eventual problems by following the debt (the mortgage debt trail led to the banking system). This time is different as a lot of the government debt that has been created has been monetized and is on central banks balance sheets. Central bank policies have depressed risk free rates and inflated asset prices. Instead of following the debt this cycle, I believe it’s more important to follow the asset inflation.

In my opinion, areas of accumulated asset inflation is where the risks of this cycle are centered. Instead of the banking sector catching most of the heat when this cycle ends, I believe it will be fully invested mutual funds, ETFs, pension funds, hedge funds, private equity funds, and any other financial vehicle that is underpricing risk and holding a pile of inflated assets.

When investors determine central bank policies are ineffective or counterproductive, the unlimited central banker bid will disappear. When that occurs, how will set prices respond when they become unset? I’ve managed small cap stocks for 20 years and I know what it’s like when the bid goes away. It’s not pretty. People panic. Large investors who need to get out drive prices down until they find a sizable bid. Before that bid can be found, there is a large air pocket. How all of these funds locked and loaded in risk assets will be able to find buyers during the next market liquidation is beyond me, especially given the sharp increase in ETFs and index fund investing.

In the meantime, investors aren’t very concerned. In fact, many investors are pressing their bets.  According to a recent Bloomberg article, “Professional speculators are making record bets in volatility markets that U.S. stocks will keep rallying.” The volatility index VIX traded near 11 last week. Another Bloomberg article quoted a trader as saying the VIX dropping below 11 by end of month is “very possible” in a market that central banks built “with lower rates and asset buying and money.” The investor also said, “It’s a “Field of Dreams” market because “if you build it, they will come”; “central banks built it” and “investors have come”.

Is this investing?